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On Our Radar

Altria Group Inc.'s Biggest Failure in 2016

Election Day 2016 didn't just bring a big change to the White House. It also heralded a major defeat for Altria Group (NYSE: MO), one that many believe could be a sign of even worse things to come not just for the Marlboro maker but for the entire U.S. cigarette industry. For Altria, however, the focus was on the West Coast, where California voters overwhelming supported a state ballot initiative that will result in a huge increase in state tobacco taxes. Given the importance of the California market, Altria, Reynolds American (NYSE: RAI), and other cigarette makers will all suffer as a result of their collective failure to persuade California voters to defeat the initiative.

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Image source: U.S. Mint.

California's Proposition 56: How it hammered Altria and its peers

The tobacco industry has been a popular target for state governments seeking to raise revenue for various purposes, and the 2016 election season was no exception for Altria and its fellow manufacturers. Proposition 56 in California was designed to increase tobacco product taxes dramatically, taking anticipated revenue and using it to fund healthcare programs, tobacco use prevention and control programs, and disease research on tobacco-related illnesses, as well as some ancillary uses such as law enforcement, physician training, and dental disease prevention. Unlike advocates of similar provisions in some other states, California activists foresaw the potential for reduced cigarette consumption as a result of the higher tax, and they therefore put in fail-safe mechanisms to ensure level funding of existing programs supported by tobacco taxes currently.

The result of the vote left no doubt as to the magnitude of the tobacco industry's loss. About 63% of voters supported the proposition, rejecting the arguments that opponents of the proposition had made that the primary beneficiaries of the measure would be health insurance companies rather than other stakeholders. Instead, they seemed persuaded by familiar arguments that many have made nationwide in support of higher cigarette taxes, noting that encouraging quitting and discouraging younger people from smoking in the first place are worthy goals.

As a result of the vote, tobacco taxes will triple, with a $2 boost in the per-pack cigarette tax to $2.87 to take effect on April 1. Given that California is the nation's second-largest market, with about 8% of the country's total volume, the impact will be substantial.

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What's to come for Altria and the cigarette industry

Just about the only good news for Altria, Reynolds American, and their peers was that things could have been worse. Similar ballot measures in North Dakota, Colorado, and Missouri went down to defeat. Yet the Colorado vote was much closer, and some fear that future efforts elsewhere could be more successful. In particular, Indiana Republican House Speaker Brian Bosma has said that a cigarette tax might be an integral part of a package to fund road maintenance and repair needs, and some believe that with Vice President-elect Mike Pence's move to Washington in January, higher taxes on tobacco could be easier to achieve in Indiana.

Still, longtime investors in Altria and Reynolds American have seen the two tobacco giants overcome long odds before. Cigarette taxes have climbed steadily across the nation, yet so far, the two companies have managed to find ways to implement price increases of their own in to offset the falling demand from higher taxes.

One new challenge, though, could come from California's initiative. The ballot proposition specifically included electronic cigarettes and other tobacco alternatives within their purview, closing off one potential strategy that Altria and its peers could have used in emphasizing reduced-risk products over traditional cigarettes. Both tobacco giants are likely to continue their work toward developing cigarette alternatives regardless of taxation, but both would clearly benefit if taxing authorities give those alternatives preferential treatment.

Higher taxes are never good news for companies, and the California ballot initiative's victory was a big defeat for Altria, Reynolds American, and other tobacco companies serving the Golden State. Investors will have to see whether other states move forward with similar initiatives in determining the long-term effect the measure could have on profitability going forward.

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